Enron and Merrill, Greece and Goldman

Did big banks break the law during our recent global debt-fuelled boom? The usual answer is: no – they just took advantage of loopholes and captured regulators. The world’s biggest banks are widely supposed to be too sophisticated to be tripped up by the legal system.

The failure of Lehman therefore opens a can of worms for close and potentially productive examination in coming weeks. But so does the issue of Greek government debt in April 2002.

According to an offering circular dated 22 April 2002, The Hellenic Republic offered 3.5 billion of bonds, due 22 October 2022, that “will bear interest from, and including, 24 April 2002 at the rate of 5.90 per cent”. The joint lead managers include, from the international side, Goldman Sachs, Morgan Stanley, and Deutsche Bank.

Goldman has, of course, admitted it helped manage down reported Greek debt levels through off-balance sheet transactions in 2000 and 2001. Gerald Corrigan, a senior Goldman executive, speaking before the UK Treasury Select Committee recently, said that the reduction in reported Greek debt was “small but significant”; in fact, it was around 1.6 percentage points of GDP, which is not small.

(From the Bloomberg story on Corrigan’s testimony: “The transactions reduced the country’s deficit by 0.14 percentage points and lowered its debt as a proportion of gross domestic product to 103.7 percent from 105.3 percent, according to Goldman Sachs.” See also the less forthright Goldman Sachs statement on the company’s website.)

The April 2002 offering circular did not disclose the debt swaps. There may have been other documentation available to investors that did reveal true Greek debt numbers – and perhaps these were discussed in the relevant road shows. We are not here taking a position on what was and was not disclosed; this is a matter for a proper official investigation. We also do not know what the other involved banks knew and when they knew it.

If it were the case that Greece’s true debt levels were known and not disclosed by the investment bankers involved, any reasonable investor – or the sovereign debt experts with whom we have discussed this matter – would regard this as withholding adverse material information.

Gerald Corrigan, who is also former head of the New York Fed, argued that Goldman did “nothing inappropriate” – but he was referring to the off-balance transactions of 2000-2001. He has not yet spoken in public about the potential nondisclosure of material information in April 2002 (and perhaps at other dates after the Greece-Goldman swaps).

As Senator Kaufman points out in his latest speech, there is nothing necessarily illegal about any non-disclosure in Europe – these bonds were issued under Greek law. And these bonds were definitely not registered under the US Securities Act of 1933; this is clear in the prospectus.

However, if any of these bonds were sold in the US to “qualified institutional buyers” (QIBs) under rule 144A (an exemption to registration requirements under the 1933 Securities Act), there is a potential legal issue (here I’m just rewording what Senator Kaufman said). Rule 10b-5, under the 1934 Securities Exchange Act, definitely applies to securities sold under 144A – i.e., selling securities to anyone in the United States while deliberately withholding material adverse information is not allowed.

Some people in the market think that around 10 percent of this Greek debt issue was sold under Rule 144A to QIBs; such sales may or may not have been handled by Goldman. Again, this can only be determined by an official investigation – hopefully the Senate Judiciary Committee, on which Senator Kaufman serves, can take this up.

Goldman could be sued by investors who feel they were misled in this fashion – although, realistically, it would only happen if the bonds default; the cost of annoying Goldman otherwise is too high. Most likely Goldman will reach an amicable agreement with any aggrieved parties. (Merrill’s problem was that Enron failed – as with Lehman, this launched an extensive set of enquiries).

Whether the SEC or any attorney general (e.g., in New York) will take any action, civil or criminal, remains to be seen. It is obviously hard – for legal and political reasons – to take on and prevail against one of the world’s biggest and most powerful banks. Too big to fail banks are also too big to sue successfully – unless they collapse (which is why we keep coming back to Lehman). (Among other things, in the Greece case there would likely be a big argument about whether the Statute of Limitations applies and to whom.)

In any case, it is time to close the loophole that effectively allows deception regarding securities sold into the United States. Rule 144A should be abolished — US residents (individuals and institutions) should only be allowed to buy securities that are properly registered with the SEC.

If other countries are willing to have their people buy fraudulent securities, that is their problem. This is no longer acceptable in the United States.

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